WEEK 2 Debt finance

Why debt finance?

• For many private companies, it may in practice be difficult to raise money through equity finance, since private companies are unable to offer shares to the public (s 755 CA 2006).

• An alternative option to raise finance for any company is to borrow money (debt finance), usually from a bank.

• While there are many types of debt finance available under different names, they can all be classified as either loan facilities or debt securities.

• Most companies will have unrestricted power to borrow. However, it is necessary to check the company’s articles to ensure that there are no restrictions.

• A lender will wish to ensure that they are protected as far as possible from the possibility that the borrowing company may be unable to repay the loan. A key method of protection is for the lender to take security over the assets of the borrowing company.

Types of debt finance? (loan facilities and debt securities)

Loan facility = Is an agreement between a borrower and a lender which gives the borrower the right to borrow money on the terms set out in the agreement.

Loan facilities include:

1. Overdraft = This is an on-demand facility, which means that the bank can call for all of the money owed to it at any point in time and demand that it is repaid immediately. This makes overdrafts unsuitable as a long-term borrowing facility.

2. Term loan = This is a loan of money for a fixed period of time, repayable on a certain date. The lender cannot demand early repayment unless the borrower is in breach of the agreement. The lender will receive interest on the loan throughout the period.

3. Syndicated bank loan = is a type of term loan. It is a large term loan provided by a group of lenders, known as a syndicate, to a single borrower. This type of loan is typically used by corporations, governments, or other large entities to fund major projects, acquisitions, or other significant investments.

4. Revolving credit facility (RCF) = This is where the borrower has flexibility to borrow and repay. It allows a company to draw down money, repay it and then re-draw it down again, then repay it. Unlike a term loan, with an RCF, the borrower has flexibility to choose when it borrows and repays as against a maximum aggregate amount of capital provided by the lender.

Debt securities:

• Do not to confuse the term “debt security”, which is a type of debt, with the term “security for a debt”, which is something that the lender will take over the assets of the borrower in order to protect their interests.

• Debt securities have some similarities to equity securities as they are a means by which the company receives money from external sources. In return for finance provided by an investor, the company issues a security acknowledging the investor’s rights. The security is a piece of paper acknowledging the debt, which can be kept or sold onto another investor.

• At the maturity date of the security, the company pays the value of the security back to the holder.

• A classic example of a debt security is a bond. Here the issuer (the company) promises to pay the value of the bond to the holder of that bond at maturity. The company also pays interest at particular periods, usually biannually.

• Bonds are issued with a view to being traded. The market on which bonds may be traded is known as the capital market.

• Whoever holds the bond on maturity will receive the value of the bond back from the issuer. Private companies can only issue bonds to targeted investors and not to the public indiscriminately. To do otherwise risks contravention of s 755 CA 2006.

What is security?

• Security, in the context of finance, means temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed is repaid (ie collateral for a debt).

• The main benefit of taking security is to protect the creditor in the event that the borrower enters into a formal insolvency procedure. It is possible to improve the priority of a debt by taking security for it.

• It should not normally be necessary to enforce security if the borrower is still able to pay, although in some circumstances, enforcing security may be a simpler way of obtaining repayment than suing the borrower.

• In the next few slides, we will explore different forms of security.

Forms of security?

1. Pledge = The security provider (usually the borrower or occasionally another company in the borrower’s group) gives possession of the asset to the creditor until the debt is paid back. Pawning a watch or an item of jewellery is a form of pledge.

2. Lien = With a lien, the creditor retains possession of the asset until the debt is paid back. An example is the mechanic’s lien. This arises by operation of law and allows a mechanic to retain possession of a repaired vehicle until the invoice is paid.

3. Mortgage = With a mortgage, the security provider retains possession of the asset but transfers ownership to the creditor. This transfer is subject to the security provider’s right to require the creditor to transfer the asset back to it when the debt is repaid. This right is known as the ‘equity of redemption.’ A type of mortgage (known as a charge by way of legal mortgage) is usually taken over land (although, unusually, ownership will remain vested in the security provider in this case).

4. Charge = As with a mortgage, the security provider retains possession of the asset. However, rather than transferring ownership, a charge simply involves the creation of an equitable proprietary interest in the asset in favour of the creditor. As well as this equitable proprietary interest, the charging document will give the lender certain contractual rights over the asset – for example, to appoint a receiver or administrator to take possession of it and sell it (or, exceptionally, to take possession of it itself to sell), if the debt is not paid back when it should be.

• There are two types of charge: fixed charges and floating charges. From a creditor’s perspective, fixed charges are generally a better form of security, but not all assets are suitable for charging by way of fixed charge.

Difference between fixed and floating charge?

Comparisons

• A fixed charge prevents the borrower from dealing with the assets subject to the charge and is the strongest form of security. A lender will normally seek a fixed charge where possible.

• A floating charge “floats” over a class of assets. It does not prevent the borrower from dealing with these assets, unless and until the floating charge “crystallises”, which usually happens when the borrower defaults on the loan repayments.

• The label applied to a charge is not always determinative. It is necessary to look at the terms of the charge itself (Agnew v IRC [2001] 2 BCLC 188, PC).

Fixed charge

• Where a fixed charge is granted, the lender will control the borrower’s use of the charged asset. The company cannot deal with (dispose of or create further charges over) the assets subject to the charge without the consent of the lender. Ashborder BV v Green Gas Power Ltd [2004].

• Though a fixed charge as it offers greater protection for the lender, such a charge is not always appropriate; it will depend on the type of assets charged.

• Fixed charges are generally taken over assets such as plant and machinery.

• if the charge becomes enforceable, the lender has the ability to appoint a receiver and exercise a power of sale over that asset.

Floating charge

• For assets that cannot be subjected to a fixed charge, a floating charge is appropriate.

• “The floating charge was invented by Victorian lawyers to enable manufacturing and trading companies to raise loan capital on debentures… without inhibiting its ability to trade.” Hoffmann J in Re Brightlife Ltd [1987] 1 Ch 200

• Re Yorkshire Woolcombers Association [1904] AC 355 defined a floating charge as a charge over: a) A class of assets, present and future; and b) Which in the ordinary course of the company’s business changes from time to time; and c) It is contemplated that until the holders of the charge take steps to enforce it, the   company may carry on business in the ordinary way as far as concerns the assets   charged.

Floating charge (crystallisation)

• When a floating charge crystallises, it ceases to float over all of the assets in a class and instead fixes onto the assets in the class charged at the time of the crystallisation. The borrower then is unable to deal with these assets, as if the assets were subject to a fixed charge.

• Whilst the effect of crystallisation on preventing the borrower dealing with assets subject to a floating charge is the same as for a fixed charge, the assets subject to crystallisation of the floating charge are not treated as fixed charge assets for distribution purposes on a winding up.

• If the company receives more assets of the same class after crystallisation, these assets are automatically subject to the crystallised charge (NW Robbie and Co v Whitney Warehouse Co Ltd [1963] 1 WLR 1324, CA).

• Crystallisation occurs in the following situations: (a) Common law: on a winding up, appointment of a receiver or cessation of business.(b) Specified event: as defined in the loan agreement. This usually occurs where a borrower   defaults on the loan repayments or interest payments, or where another lender enforces their security.

Are charges over book debts fixed or floating?

What is a book debt?

A book debt = an unpaid invoice, i.e. a sum owed to the company in respect of goods or services supplied by it. Book debts are a fluctuating asset (such debts come into existence and are then paid off) and may be a significant asset of a company.

Whether charges over book debts are fixed or floating has been the subject of much debate in the courts. We will however be exploring the evolution of the law on the issue.

Case law:

• Siebe Gorman and Co Ltd v Barclays Bank Ltd [1979] 2 Lloyd’s Rep 142 = the court held that a charge over book debts was a fixed charge because of the degree of control of the bank, which could stop the company making withdrawals, even when the account was in credit.

• Re Brightlife Ltd [1987] Ch 200 ChD = “significant feature is that Brightlifewas free to collect its debts and pay the proceeds into its bank account. Once in the account, they would be outside the charge over debts and at the free disposal of the company. In my judgment a right to deal in this way with the charged assets for its own account is a badge of a floating charge and is inconsistent with a fixed charge..” Per Hoffman J

• Re Keenan Bros Ltd [1986] BCLC 242 = a fixed charge was created by the means of a requirement that the funds collected by the company were to be paid into a blocked account. The prior written consent of the bank was required before any funds were allowed to be withdrawn from this account. Here the court said that the charge was a fixed charge due to the fact that the account was blocked.

• Re Brumark Investments Ltd [2001] = a company attempted to create a fixed charge over its book debts. The court held that the proceeds of book debts received by the company were excluded from the fixed charge unless the bank had ordered payment into an account that the company could not operate freely, which was not the case. It was held that the key issue was who had control of the proceeds and the answer determined the type of charge. Here the company’s freedom to collect and use the proceeds of the book debts as it wished without requiring the lender’s consent was inconsistent with the nature of a fixed charge. This was a Privy Council case, which means that it is persuasive but not binding.

• National Westminster Bank plc v Spectrum Plus Ltd and others [2005] UKHL 41 = the charge in issue was stated to be a fixed charge. However, the company collected its book debts, put them in an account and then drew on the account as it wished. The House of Lords held that the charge was a floating charge, agreeing with the Privy Council in Brumark.“[T]he essential characteristic of a floating charge, the characteristic that distinguishes it from a fixed charge, is that the asset subject to the charge is not finally appropriated as a security for the payment of the debt until the occurrence of some future event. In the meantime, the chargor is left free to use the charged asset and to remove it from the security.” per Lord Scott. Following this case, it is only possible to have a fixed charge over book debts if they are paid into a blocked account which gives the lender the degree of control required.

Guarantees in practise

• Strictly speaking, guarantees are not security, as guarantees do not give rights in assets.

• A guarantee for a loan means an agreement that the guarantor will pay the borrower’s debt if the borrower fails to do so.

• Example: A bank is intending to lend £20,000 to a company which was recently incorporated by an entrepreneur who is the majority shareholder in the company and is its managing director. The bank will be granted a fixed charge over certain assets. However, the bank is concerned that the value of the assets might depreciate rapidly, leaving it exposed.

• The bank could also look to take a personal guarantee from the entrepreneur if they have valuable assets. If the company defaulted, the bank could call on the guarantee and, if the entrepreneur refused to pay, sue them for the money. They may also give security for the guarantee (eg by granting a mortgage over their home, subject to any rights of any other person living there with them).

Order of priority on winding up (liquidation)

• In a liquidation, fixed charge holders are paid first in the order of priority on insolvency.

• The insolvency rules require a proportion of the floating charge assets to be set aside for the unsecured creditors. In addition, preferential debts (those payable to employees) are also paid out of the floating charge fund before the floating charge holders are paid.

• The unsecured creditors are paid after the floating charge holders, and any remaining assets are paid to the shareholders.

• Most banks therefore require a fixed charge and a floating charge, giving themselves the greatest chance to recoup their money if the company goes into liquidation.

• You will learn more about the order of priority on a winding up in the cycle on insolvency.

There are three main principles by which the law governs competing charged:

1. Fixed beats floating: This principle supersedes the chronology of the assets in question; in other words, a fixed charge created in 2025 would still take priority ahead of a floating charge created in 2020.

2. Earlier beats later: used as a “tie-breaker” where there are two or more of the same type of charge over a property. So, for example, if there are two fixed charges over a property, then the one that was created sooner (“first in time”) will take priority (“stronger in right”) ahead of the one created later.

3. Where charges are created over registered land, then those charges must be registered at the land Registry. The result of this is that the relevant date for priority purposes is no longer the date of creation of the charge, but instead the date of registration.

Registration of charges

• All charges created on or after 6 April 2013 must be registered at Companies House.

• Under s 859A(4), a charge must be registered within 21 days starting from the day after it is created. Any person with an interest in the charge may complete the registration, though in practice this is usually done by the lender, as they bear the greatest risk if registration does not occur.

• If a charge is not registered within the 21-day period, s 859H(3) provides that it is void against a liquidator, administrator, or creditor of the company. The secured debt then becomes immediately payable, and the charge holder is treated as an unsecured creditor.

• The company must keep certified copies of all registered charges at its registered office (s 859P).

Remedies for failure to register

• Although registration is mandatory, the court has discretion under s 859F to extend the time for registration where the conditions in s 859F(2) are satisfied. These include situations where the failure was accidental or due to inadvertence, or where no prejudice is caused to creditors or shareholders, or where it is otherwise just and equitable to grant relief.

• Courts will generally allow late registration provided it does not adversely affect other charges created in the period between the charge’s creation and its eventual registration. However, relief may be refused where there has been an excessive delay.

• Victoria Housing Estates Ltd v Ashpurton Estates Ltd [1982] = a charge created in 1978 was not discovered to be unregistered until 1981. The lender took no action while asset sales were ongoing and only applied to register the charge after receiving notice of a winding-up petition. The court refused to allow late registration due to the length of the delay.

Limitation periods

• A secured lender can lose their rights to enforce a secured debt by the passage of time. There are two limitation periods, created by s. 20 of the Limitation Act 1980: (1) The lender has 12 years to recover the principal sum, running from the date on which the right to receive the money accrued. (2) The lender has 6 years to recover arrears of interest, running from the date on which the interest became due.

• But, the time period restarts every time that the debtor acknowledges the debt or makes any payment in respect of it (s. 29(5) LA 1980).

Summary

• There are various different forms of security that may be granted for loans. The most common forms of security are fixed or floating charges.

• A fixed charge prevents the borrower from dealing with the charged assets.

• A floating charge floats over a class of assets. It does not prevent the borrower from dealing with the assets, unless and until the floating charge crystallises.

• A fixed charge is a stronger form of security, since the fixed charge holders are paid first in the order of priority in the event of a company's liquidation.

• Charges must be registered within 21 days, beginning with the day after creation under s 859A CA 2006; otherwise, they will be void.

• The court has a discretion to allow late registration under s 859F.